Question

Distinguish between "real-balances effect" and "wealth effect," as the terms are used in this chapter. How does each relate to the aggregate demand curve?

Short answer

The real-balances effect shows the change in purchasing power of asset balance due to price change. The wealth effect shows the change in spending due to the change in wealth.

The changing purchasing power and wealth both impact the demand and spending capacity of the individuals, hence influencing the aggregate demand curve.

Step-by-step solution

Real-balance effect

The real-balance effect captures the change in the purchasing power of asset balance, i.e., the asset's net value, because of a change in the price level. Suppose prices increase, then the purchasing power of assets will fall; thus, the consumer will have less income to spend as the asset value has fallen. The inverse relation will hold if the price is low.

Wealth effect

The wealth effect captures the change in consumer's wealth; here, the price level is assumed to be constant; the spending changes as the wealth changes. If the consumer's wealth increases, then the consumer's spending will also increase. Suppose the value of the stock falls. Then the consumer's spending will also decrease as the consumer may feel less wealthy.

Aggregate demand

The aggregate demand shows the relation of aggregate expenditure or demand in the economy at a particular price level. The real-balance effect leads the aggregate demand curve to slope downward, as with the price increase, the spending falls. The wealth effect also leads the aggregate demand curve to slope downward; spending increases with the rise in wealth.